The value of your business when you were starting out was probably negligible. Unless you purchased or inherited your business, it wasn't worth much when you opened your doors, but the proportion of your assets tied to your business may have crept up over time.
Meet business owner tom
Imagine a speculatory business owner named Tom, who starts his company at age 30. He has a little bit of equity in his first home and a small retirement fund. It is not very helpful when he starts his business, so it doesn't yet factor into Tom's net worth calculation.
By the age of 50, Tom has built up $700,000 worth of equity in his home, his retirement nest egg has grown to $500,000, and his business has blossomed and is now worth $6,000,000. Tom's company has crept up to represent 90% of his net worth.
Tom knows the first rule of investing is to diversify, which he is prudent to do with his retirement account. Nevertheless, he has failed to achieve overall diversity given the success of his business, which now equates to such a high percentage of his net worth.
Moreover, he may have unknowingly passed something called "The Freedom Point." This is when the net proceeds (i.e., after taxes and expenses) of selling his business would garner enough money to live comfortably. Your lifestyle defines your Freedom Point, but it's worth evaluating the risk you're taking when you pass it.
What to do when your business has passed the freedom point
When your business has reached the Freedom Point, there are 3 options you could consider, particularly if you are not ready to retire fully:
- Sell a Minority Stake: For minority recapitalisation, you sell less than half of your shares. Often sold to a financial investor such as a private equity firm a minority recapitalisation allows you to diversify your net worth while controlling your business.
- Sell a Majority Stake: Majority recapitalisation means you sell more than half of your shares to an investor who will most likely ask you to continue to run your business for many years to come. You get to diversify your wealth, keep some equity in your business for when the investor sells, and continue to run your company.
- Sell with an Earn-Out: You'll likely have to agree to a transition period when you sell your company. The most common one is called an earn-out, where you decide to continue to run your company as a division of your acquirer's business for a specified period. Your earn-out may be as little as a year or as long as seven, but the average is for three years. However, if you're past the Freedom Point and can see yourself wanting to step down in the following years, you may consider an earn-out.
Main takeaway
If this pandemic has taught us anything it is that nothing is for sure, and a thriving business one day can turn into a struggling company overnight. When your business makes up most of your net worth and selling it would result in money to retire, there's no financial reason to continue owning your business.
You may enjoy the challenge, the social interactions, and the process of building a business, but keeping it may be unnecessarily difficult.
